Are Canadian Family Businesses Ready for Succession ?

The importance of family businesses in Canada cannot be overstated. The term “family business” generally implies that the firm is both family owned and family managed.[ 1 ] Their importance to Canada follows from two characteristics. First, they are the dominant form of business in Canada accounting for a significant portion of our wealth and employment. According to Stavrou and Swiercz, “family-owned firms… constitute 80% of all Canadian businesses and generate $150 billion in sales.”[ 2 ] These firms account for about one half of Canada’s gross domestic product and employment.[ 3 ] Second, it may be argued that family businesses have particular attributes that make them more valuable to the nation— that family businesses enjoy a competitive advantage. These attributes include higher levels of trust,[ 4 ] greater focus on building customer loyalty, more active role in the community, a culture of shared values[ 5 ] and a more long-term perspective.[ 6 ] Family businesses may also be nimbler, more customer-oriented and more quality focused—perfectly suited for the global competition.[ 7 ] Porter argues that family businesses provide a competitive advantage to a nation through sustained commitment to the firm and industry, and greater flexibility.[ 8 ]

It has been repeatedly argued that the greatest risk to the continued success of family business is succession — the passing of the business from one generation to the next.[ 9 ] Succession planning for family businesses can be far more difficult and important than for non-family corporations, in that such planning must include far more than the determination of a successor.[ 10 ] Family dynamics are critical.[ 11 ] If the family has not “bought into” the succession plan, the firm may not survive.[ 12 ] Financial and legal issues are also more likely to be important to a family business than to a non-family business. Often, if financial and legal considerations are not planned, the firm will need to be sold or divided to pay a tax liability on the parent’s death, or to satisfy claims by the children or spouse.

However, there are factors that may work against preparedness. First, in focusing on the day-to-day operations, the parent may have given little consideration to how it will continue. Second, preparing the firm for succession usually involves making and communicating hard choices that affect both the business and the family,[ 13 ] but the parent may want to avoid the inevitable conflict involved.[ 14 ] Third, the parent may not fully understand the importance of succession readiness. Finally, the parent may believe that they can take care of succession planning at some later date.[ 15 ]

The level of succession readiness for Canadian family businesses is an empirical issue that has not previously been addressed. In the following section, we define succession readiness. The survey is then discussed, followed by results and analysis. Conclusions and policy implications complete the paper.

Succession readiness

Defining readiness

Succession readiness is a construct. There is no single element that can, in itself, define whether a family firm is prepared for succession. However, it is possible to look for themes or dimensions of readiness. We classify succession readiness along three themes or dimensions: family readiness, financial readiness and legal readiness. We believe this classification is intuitive, has descriptive power and is largely consistent with prior literature.[ 16 ]

The family business literature has emphasized the importance of family readiness on succession. Family readiness may be defined to include a process for the selection of a successor,[ 17 ] communication with one’s children and spouse[ 18 ] and the existence of formal contingency plans.[ 19 ] Financial readiness would normally include insurance to allow the business to continue to function if the parent dies or is disabled, a financial plan for the future and an understanding of the level of tax liability on succession and how it would be funded.[ 20 ] Legal readiness insures that the parent’s intentions are followed, and that the firm can continue to operate through the succession transition. It will normally include, as a minimum, the existence of a will and a power of attorney.[ 21 ]

Hypotheses

Anecdotal evidence exists that family businesses are not prepared for succession.[ 22 ] However, this conjecture has not been formally examined in a Canadian context. Our first hypothesis is, therefore, that a significant proportion of family-owned businesses are not prepared for succession. We hypothesize that this non-preparedness conjecture would hold for our three measures of readiness — family readiness, financial readiness and legal readiness.

Our second hypothesis is that, the closer in time a parent is to retirement, the higher the level of succession readiness. The rationale for this hypothesis is that, as a parent approaches retirement, the importance of succession planning should be more evident — in effect, the parent can no longer put off tough decisions.[ 23 ] We would expect that this hypothesis would hold across our three measures of succession readiness. However, anecdotal evidence suggests that the effect may be most pronounced on family readiness since some claim that certain decisions, such as choosing a successor, should not be made prematurely.[ 24 ] Further, and perhaps more important, family readiness for succession may be delayed as parents may not want to discuss issues that will create significant family conflict until they feel it is absolutely necessary.[ 25 ]

The survey

To examine the level of succession readiness in Canadian family businesses, a survey was administered using a self-completion mail questionnaire. In the summer of 1998, the survey was mailed to a nationally representative sample of Canadian family-owned businesses obtained from Dun & Bradstreet.[ 26 ] A total of 7500 questionnaires were mailed to businesses that met the following criteria: annual revenues of at least $1 million; domestic headquarters only; domestic parent companies only; not publicly traded; not a sole proprietorship; and not a partnership. A total of 765 surveys were returned, representing a 10.2 percent response rate.[ 27 ] The regional distribution of returned surveys closely matched the distribution of the mail-out.

The responding businesses tended to be larger than the average family firm — this is a result of requiring annual revenues of at least $1 million. The most frequently reported sales revenue figure was $2 million. One-half of these family businesses employed 18 or more full-time people. Note that the $1 million revenue threshold created a bias in favour of succession readiness. If the firms we surveyed are not prepared for succession, smaller firms are likely to be even less prepared.

Analysis

In this section, we analyze the level of succession readiness for each of the three measures: family readiness, financial readiness and legal readiness. The level of readiness is further examined in relation to the parent’s expected time to retirement. Note that in our survey, 199 respondents indicated they would retire in the following five years, 217 in six to 10 years, 167 in 11 to 15 years, and 165 after 15 years. That over a quarter of the respondents will retire in the next five years, and over a half within 10 years, indicates that succession is close for many of the respondents.

Common to the following analysis, each item in the three measures was found to be significantly different from succession readiness at the one percent (0.01) significance level. Restating, we found that the first hypothesis, that a significant proportion of family-owned businesses are not prepared for succession is statically significant. These results, however, are not particularly interesting — with the size of our sample, even a relatively high level of succession readiness would be statistically different from full readiness. More interesting, is the level of non-preparedness, which is what we focus on below.

Family Readiness

The survey results for family readiness are presented in Table 1.

In determining the level of family readiness, we measure choice of successor, communications with children and contingency planning.

From Table 1, one can see that only 30.5 percent of the family business sample had chosen a successor — more important, for those who will retire in the next five years, only 44 percent have chosen a successor. In other words, of Canadian family businesses that will be passed on in the next five years, less than 50 percent have chosen a successor. Further, among those that have not chosen a successor, few have a process for selection in place. Only 34.4 percent of respondents indicated that they had established a process for selecting a successor. This is approximately the same percentage as firms that have chosen a successor, 30.5 percent. An implication is that very few firms that have not already chosen a successor have put in place a process for that selection.

Effective communications within one’s family is generally considered to be very important to effective succession.[ 28 ] At a bare minimum, it is believed that the children should understand their future role in the firm. From Table 1, we see that only 26 percent of parents have discussed the division of their estate with their children—even more surprising, among parents who will retire in the following five years only 36 percent have had this discussion. It appears that parents do not discuss succession with their children, even when succession is imminent.

To offset the difficulties facing the executor, it is argued that contingency plans should be established.[ 29 ] While a written contingency plan will not have legal authority, it can provide solid advice for dealing with business matters that will be faced until the assets can be turned over to the beneficiaries. The survey indicated that most family businesses do not have written contingency plans — only 37 percent have contingency plans in case of the parent’s death, and even fewer, 31 percent, have plans in case of disability.

From Table 1, it appears that, consistent with our second hypothesis, family readiness increases on each item as the parent approaches retirement. To test this hypothesis formally, each of the five measures was regressed against the parent’s years to retirement. An assumption underlying most regression models is that the dependent variable can assume any value within a range — that is, the left-hand-side variable is assumed to be continuous. However, this assumption is violated in testing the second hypothesis as the response that forms each dependent variable is categorical. For example, in responding to whether a successor has been chosen, the respondent will answer either yes or no, a discrete choice with two possible outcomes. The coefficient in each case was in the hypothesized direction, the level of family readiness increased the closer the respondent was to retirement, and was significant at the one percent (0.01) level.[ 31 ] Therefore, the hypothesis that family readiness increases as the parent approaches retirement is strongly supported.

To summarize, the overall level of family readiness for succession in Canada is very low. As expected, this level of readiness does increase as the parent approaches retirement, but continues to be at a surprisingly low level. Most Canadian family businesses are not prepared on the family readiness dimension for succession — even where succession is imminent.

Financial Readiness

Financial readiness, as presented in Table 2, is measured through examining the parent’s use of insurance, business and strategic plans, and tax readiness.

Key person insurance is important as it allows the business to continue to function if the parent dies or is disabled.[ 32 ] Most firms had key person insurance on the parent’s life (72%) and a slight majority had key person disability insurance (52%). Personal life insurance is an indicator of financial readiness in that it allows the family, on the death of the spouse, to pay taxes, provide for survivors, and take other actions with respect to the firm. Almost nine of every ten respondents held personal life insurance (87.7%).

Similar to previous research,[ 33 ] written business plans were not as common as one might expect; only 40 percent of the family businesses had one. A business plan, as defined in the survey, is an annual written document dealing with such aspects as marketing, capital expenditures, cash flow, research and development, income and expenses, and financing requirements. Businesses often compare actual results to this plan on a regular basis (weekly, monthly, quarterly, annually). Even less common were written strategic plans — only 21 percent of firms had written strategic plans. A strategic plan was defined in the survey to be a longer-term written plan covering three or more years. Given the significance of the business to most parent’s estates (52% of respondents reported the business is greater than 50% of their estate, 16% reported it is greater than 75% of their estate), it was surprising that only 37 percent knew what the tax liability to the estate would be if they were to die today. While very few parents knew their tax liability, most (67%) felt their estate would have the resources to fund the liability. However, 28 percent of parents that were going to retire in the next five years did not know how their tax liability would be funded.

Somewhat surprising, financial preparedness does not appear to increase as the parent approaches retirement. This is confirmed through regressing the seven measures of financial readiness on the parent’s years to retirement, using logit and probit models. Only one of the seven measures, “have knowledge of estimated tax liability,” was significant at conventional levels (at the 0.05 level). The second hypothesis, therefore, is not supported — financial readiness does not increase as the parent approaches retirement.

To summarize, except for the existence of personal life insurance, family businesses generally seem financially unprepared for succession. Somewhat surprisingly, the level of preparedness is independent of the timing of retirement by the parent — that is, whether a parent will be retiring in two years or in 16 years seems to have little effect on his or her financial preparedness. An exception is that parents are more likely to know their tax liability the closer they are to retirement.

Legal Readiness

The overall level of legal readiness for family businesses, as presented in Table 3, appears low.

Less than 50% of survey results indicated that the person employed a power of attorney. They also didn’t have a shareholders agreement in place and didn’t have instructions in place in case of undesirable circumstances coming about. In addition, a full 71% indicated they had no wills in place to ensure an amicable division of assets. More surprising is that only 77% had gone through the exercise as the parent was getting towards retirement age. It’s worth noting here that not having something in place to account for an unexpected death can lead to dire consequences for the company.

It appears from Table 3 that the level of legal preparedness does tend to increase as the parent approaches retirement. In regressing the four measures of legal readiness on the parent’s years to retirement, again using logit and probit models, we found that “will” and “power of attorney” were significant at the one percent (0.01) level, “letter of instruction” was significant at the five percent (0.05) level and “shareholder’s agreement” was not significant. The second hypotheses is at least weakly supported.

Measures of succession readiness

Three dimensions of succession readiness were examined above: family readiness, financial readiness and legal readiness. These dimensions were used both because they were intuitive to the authors and were consistent with the prior literature. Statistically, there is also evidence that the three dimensions are somewhat distinct. For each of the dimensions, there was much greater correlation within items in a dimension than items across dimensions. For example, key life insurance and key disability insurance are significantly correlated (within the financial readiness dimension), but neither are significantly correlated with whether a successor has been chosen (family readiness dimension) or whether the parent has a will (legal readiness dimension). For family readiness, 67 percent of items within a dimension and only 10 percent across dimensions were correlated in the hypothesized direction at the five percent (0.05) significance level; for financial readiness 19 percent within a dimension and 8 percent across dimensions were significantly correlated; and for legal readiness 50 percent within a dimension and zero percent across dimensions were significantly correlated.

Conclusions and policy implications

While it is apparent that the health of family-owned businesses is strategically important to Canada, the overall level of succession readiness is surprisingly low — this is true for family readiness, financial readiness and legal readiness.

Previous research into the topic has illustrated that only 33% of businesses actually make it to the second generator. The fact of the matter is, without a sound plan in place in regards to the family, financial and legal matters, the chance at having a successful business into the next generator is fairly slim. It is also clear that Canadian family-owned businesses are not becoming sufficiently prepared even when the current decision maker approaches retirement. We found that as the parent approaches retirement, there was a large increase in level of family readiness, a smaller increase in legal readiness and no increase in financial readiness. However, even where the level of readiness increases as the parent approaches retirement, absolute levels of preparedness remain very low.

Canada has attempted to provide support for family business succession (largely through the income tax system). In particular, the federal government has enacted measures that reduce or delay tax consequences on succession. For example, Canada’s income tax structure allows a parent to take a $500,000 lifetime capital gains exemption on qualified small business corporate shares, and to transfer the future growth in the corporation to the child on a tax-deferred basis (an estate freeze). However, for a family to take advantage of these provisions (especially an estate freeze) it is crucial that there is succession readiness. There does not appear to be appropriate policy in place to help increase readiness. The results of this article appear to imply that merely creating appropriate economic incentives may not be effective in ensuring that family businesses will survive succession. If, through a lack of succession readiness, businesses are not surviving the succession process, this may cause dislocation and have a profound effect on employment and the competitiveness of Canada as a nation.

Tammi S. Feltham is Associate Professor in the Department of Management & Marketing, and Glenn Feltham is Professor and Department Head of Accounting, both at the University of Saskatchewan. Jim J. Barnett is Director of the Deloitte & Touche Centre for Tax Education and Research, and Director of the Master of Taxation Program, School of Accountancy, University of Waterloo. The authors would like to thank colleagues at the University of Saskatchewan and the University of Waterloo for helpful comments and suggestions. They would also like to thank the Deloitte & Touche Centre for Tax Education and Research at the University of Waterloo for providing funding for this project.

3. To make this assertion, the results from various sources are combined. First, Francois Beudoin (1996), in a speech to the Canadian Club of Toronto on December 4, 1995, stated “small business now accounts for a full 57% of Canada’s gross domestic product.” In addition, this percentage is growing. Beudoin noted that over the last 15 years small businesses have “posted a spectacular 49% growth in employment” while other sectors have provided a steady decline. Second, in Statistics Canada, “Strategies for Success,” Catalogue 61-523R E (1994), it is reported that small businesses, firms with fewer than 500 employees, accounted for 63% of all Canadian employment in 1989. Given estimates that at least 80% of small businesses are family businesses (e.g., Stavrou and Swiercz, op. cit.), it follows that family businesses account for about one half of gross domestic product and employment.

16. In discussions of the family succession process, similar categories have been used. For example, Dyer and Handler, op. cit., state that succession involves, “family dynamics, non-family employees, business dynamics, and technical legal and tax issues,” and Montgomery and Sinclair, op. cit., note, “Families in business together must deal with family issues at the same time they deal with routine legal, financial, and strategic business planning issues.”

26. Constructed databases by Dunn & Bradstreet have been used extensively in the business literature (S. Cromie, B. Stephenson and D. Monteith, “The Management of Family Firms: An Empirical Investigation,” International Small Business Journal, Vol. 13, no. 4 (July-September 1995), pp. 11-35; K. Smyrnios, C. Romano and G. Tanewski, “The Australian Family Private Business Survey: 1997,” National Mutual Life Association, Australia (1997); K. Smyrnois, G. Tanewski and C. Romano, “Development of a Measure of the Characteristics of Family Business,” Family Business Review, Vol. 11, no. 1 (March 1998), pp. 49-59.

27. This response rate is similar to other studies using Dunn & Bradstreet data.

30. More formally, logit and probit regressions were performed on the form, yi = _0 + _1xi + _i, where yi takes the value 0 or 1 (e.g., yes or no to the question, “Have you selected a successor?”), xi is the category for the number of years until retirement for respondent i, and _i is the error term for respondent i.

31. The results were invariant to whether logit or probit was performed.